Auditing and Assurance: Concepts and Applications 1
Auditing and Assurance: Concepts and Applications 1
Table of Contents
Auditing and Assurance: Concepts and Applications 1
Cash is a legal tender that can be used to exchange goods, debt, or services. It is one of the most important
assets of a business. Almost all the entity's transactions ultimately result in either receipt or payment of
cash. Cash usually includes cash in bank, cash on hand, and cash equivalents. Cash equivalents (CE) are
short-term, highly liquid instruments that are both easily convertible to a known amount of cash. Examples
of cash and cash equivalents include, but not limited to, petty cash fund, payroll fund, money orders,
cashier's checks, treasury bills, and others.
Included as CE Excluded as CE
Cash Equivalents (CE)
1. Time deposit ✓ (within 3 months) ✓ (beyond 3 months)
2. Money order ✓ (within 3 months) ✓ (beyond 3 months)
3. Treasury shares ✓ (within 3 months) ✓ (beyond 3 months)
4. Investment in preference share with
✓ (within 3 months) ✓ (beyond 3 months)
redemption date
Introduction to Receivables
Receivables are debts owed to a company by its customers for goods or services delivered or used but
not yet paid for.
The audit of receivables and revenue (e.g., sales) represents significant audit risk because:
1. Many incidences of financial statement fraud have involved the overstatement of receivables and
revenue;
2. Revenue recognition may be based on complex accounting rules; and
3. Receivables and revenue are usually subject to valuation using significant accounting estimates.
Expected question(s):
1. What is the balance of accounts receivable at year-end?
2. What is the balance of allowance for doubtful accounts at year-end?
3. What is the amount of bad debt expense for the year?
4. What is the net realizable value of accounts receivable at year-end?
Notes Receivable
Notes receivable is a balance sheet item that records the value of promissory notes that a business is owed
and should receive payment for. A written promissory note gives the holder, or bearer, the right to receive
the amount outlined in the legal agreement. Promissory notes are a written promise to pay cash to another
party on or before a specified future date.
If the notes receivable is due within a year, it is treated as a current asset on the balance sheet. If it is not
due until a date that is more than one year in the future, then it is treated as a non-current asset on the
balance sheet.
Expected question(s):
1. What is the initial measurement of notes receivable (fair value at the date received)?
2. What is the gain or loss on the sale of property, plant, and equipment?
3. What is the amount of revenue or sales where the consideration received is in the form of notes?
4. What is the subsequent measurement of notes receivable (carrying amount at year-end)?
5. What is the interest income for the year?
6. What is the interest receivable as of year-end?
7. What is the current portion of the notes receivable?
8. What is the non-current portion of the notes receivable?
Receivable Financing
• Assignment of Accounts Receivable. It is an agreement between a lending company and a
borrowing company in which the latter assigns its accounts receivable to the former in return for a loan.
• Factoring. Factoring is a financial transaction in which a company sells its accounts receivable to a
financing company specializing in buying receivables (called a factor) at a discount.
• Discounting of Notes Receivable. A holder of a note can readily convert it to cash by discounting it
at a bank, either with or without recourse. The bank accepts the note and gives the holder cash equal
to its maturity value less a discount computed by a discount rate to the maturity value. The bank gets
its money back plus the discount when its maker pays the note at maturity. If the note is not paid at
maturity, the bank can collect it from the original holder if it was discounted with recourse. If the
arrangement is without recourse, the bank must find another remedy.
a. Discounting without recourse – The holder/endorser is not held liable in case the maker fails to
pay.
b. Discounting with recourse – The holder/endorser is held liable in case the maker fails to pay.
The discounting is accounted for either (a) conditional sale, or (b) secured borrowing.
Expected question(s):
Assignment
1. What is the balance of accounts receivable - assigned?
2. What is the balance of loans payable?
3. What is the equity to be disclosed in the notes to the financial statement?
Factoring
1. What is the net proceeds from factoring of receivable?
2. What is the cost of factoring?
Discounting
1. What is the net proceeds from discounting of notes receivable?
2. What is the gain or loss from discounting of notes receivable?
3. What is the journal entry for discounting of notes receivable?
Introduction to Inventories
Inventories are assets held for sale in the ordinary course of business, in the process of production for such
sale, or in the form of materials or supplies to be consumed in the production process or the rendering of
services.
Inventories
Goods in transit
Shipping Terms Owner
1. Lay-away sale
2. Sale on approval Seller
3. Sale with a buyback agreement
Inventoriable expenditures
Expenditure Treatment
1. Freight
a. Freight-in Inventoriable
b. Freight-out Not inventoriable
2. Insurance
a. During delivery Inventoriable
b. After delivery Not inventoriable
3. Storage cost
a. Storage of Work-in-process Inventoriable
b. Storage of Raw Materials and Finished goods Not inventoriable
4. Waste, spoilage of resources
a. Normal Inventoriable
b. Abnormal Not inventoriable
5. Interest incurred
a. Non-routinely manufactured Inventoriable
b. Routinely manufactured/ Silent Not inventoriable
6. Tax
a. Non-recoverable Inventoriable
b. Recoverable Not inventoriable
Introduction to Investments
Investments are financial assets representing a company's right to receive cash from its stake in bonds,
shares, real estate, etc. The intent behind making such investments is to generate investment income
(interest and dividend) and benefit from expected capital gain.
From the auditors' point of view, the most important group of investments consists of stocks and bonds
because they are found more frequently and usually are of greater value than other kinds of investment
holdings. Commercial papers issued by corporations, mortgages and trust deeds, and the cash surrender
value of life insurance policies are other types of investments often encountered.
Under International Financial Reporting Standards (IFRS), classification depends on (a) the business model
and (b) cash flow characteristics of the instrument. An investor first determines whether its business model
holds the asset to collect cash flows or sell it to realize a capital gain. Second, it assesses whether the
asset's cash flows are solely payments of principal and interest (called the SPPI test). Categories of debt
securities under IFRS include:
a. Amortized cost. Debt securities are classified at amortized cost if the company's business model
is to hold the asset to collect cash flows. Those cash flows are solely payments of principal and
interest.
b. Fair value through other comprehensive income (FVOCI). Debt securities are classified at
FVOCI if the investor's business model collects cash flows and sells the asset. The cash flows are
solely payments of principal and interest.
c. Fair value through profit or loss (FVPL). These are debt securities that do not qualify for
classification at either amortized cost or FVOCI are classified at FVPL.
a. Investment in a subsidiary. It is based on controlling interest, and the financial statements may
be consolidated. Control may be obtained in various circumstances and not solely due to direct the
financial and operating policies. An investor controls an investee when it is exposed, or has rights,
to variable returns from its involvement with the investee and can affect those returns through its
power over the investee. Where Company A owns more than 50% equity of Company B, it has
control over Company B and is required to prepare consolidated financial statements.
b. Investment in associates. The investor classifies the equity investments as investments in
associate when there is a significant influence in the investee company's operating and financial
policies. Company A owns anywhere between 20% and 50% of Company B's equity. It has
significant influence over Company B. It is required to account for investments in Company B using
the equity method.
c. Fair value through profit or loss (FVPL) – This is the classification when the equity securities are
held for trading. There is neither control nor significant influence in the operating and financial
policies of the investee company.
d. Fair through other comprehensive income (FVOCI) – When there is neither control nor
significant influence and the equity securities are non-trading, the investor makes n irrevocable
choice designating at the date of initial recognition of the securities either as FVPL or FVOCI.
For example, If Company A owns less than 20% of Company B's equity, neither consolidation nor
equity method is required.
The term Property, plant, and equipment (PPE) refer to tangible items that:
a) are held for use in the production or supply of goods or services, for rental to others, or
administrative purposes; and
b) are expected to be used during more than one period.
PPE normally constitutes a significant portion of the total assets, particularly in a manufacturing entity. Audit
of PPE, therefore, assumes considerable importance. When planning for the audit of PPE, the auditor
considers that the amounts for this PPE is material to the statement of financial position and expect that
the account balances do not necessarily change significantly from year to year.
The auditor normally assesses control risk at a maximum level and performs extensive substantive tests
that emphasize the review of significant additions, disposals, and analytical procedures to test the
provisions for depreciation and depletion. In addition, auditors should also obtain evidence about related
accounts of depreciation expense, accumulated depreciation, lease (rent) expense, impairment loss (if
any), and repairs and maintenance expense.
Bearer biological assets (BBA) are matured biological assets held for more than one financial period
capable of bearing consumable biological assets (CBA) to be harvested as agricultural produce. BBA are
held for generating income from the sale of produce; for example,
1. Livestock from which milk is produced
2. Grapevines
3. Oil palm and rubber trees
4. Fruit trees, and
5. Trees from which firewood is harvested while the tree remains.
Bearer biological assets are not agricultural produce but, rather, are self-regenerating. Bearer plant assets
are accounted as PPE under PAS 16, provided it will meet the criteria in the said standard, while bearer
animals are accounted as biological assets under PAS 41. Produce growing on bearer plants is a biological
asset.
Purchase Price
Cash basis 1. Cash
2. Lump-sum/basket price - allocate on the basis of relative fair value
On account 1. Invoice price minus cash discount, whether taken or not
Installment Method 1. Cash price equivalent
2. Present value if no cash price equivalent
Issuance of share capital 1. FV of property received
2. FV of share capital
3. Par value or stated value of share capital
Issuance of bonds 1. FV of bonds payable
payable 2. FV of property received
3. Face value of bonds payable
Depreciation Methods
1. Straight line
• Depreciable amount / useful life
• Depreciable amount x depreciable rate
2. Group / Composite
• Cost x depreciation rate
Depreciation rate = Annual depreciation / total cost
3. Units of production
• Output x Depreciation rate
Depreciation rate = Depreciable amount / Total estimated output
4. Working hours
• Hours used x depreciation rate
6. Declining
• Previous carrying amount x depreciation rate
Regular = 1 – (nth root of (Residual value /cost)]
150% = (1 / useful life) x 1.5
200% = (1 / useful life) x 2
7. Retirement
• Cost of asset retired – Proceeds from retirement
8. Replacement
• Replacement cost of asset retired – Proceeds from retirement
9. Inventory
• Recorded balance of asset – Value at period end
Intangible assets include patented technology, computer software, trademarks, copyrights, formulas,
franchise agreements, and goodwill acquired in a business combination. Since intangible assets lack
physical substance, their value lies in the rights and economic advantages afforded in their ownership.
Because of their intangibility, they are more difficult to identify than other assets like property, plant, and
equipment.
An intangible asset can be classified as either:
• Indefinite life: No foreseeable limit to the period over which the asset is expected to generate net
cash inflows for the entity. A company's brand name is considered an indefinite intangible asset
because it stays with the company for as long as it continues operations.
• Finite life: A limited period of benefit to the entity. An example of a definite intangible asset would
be a legal agreement to operate under another company's patent, with no plans of extending the
agreement. The agreement thus has a limited life and is classified as a definite asset.
3. Outflow of future economic benefits - This states that all accounting liability requires the payment of
money, non-cash assets, or certain service performance.
PAS 1 Presentation of Financial Statements provides two (2) classifications for liability: current liability
and non-current liability.
Current Liabilities
As discussed in PAS 1, an entity shall classify a liability as current when (International Financial Reporting
Standards, 2001):
• It expects to settle the liability in its normal operating cycle;
• It holds the liability primarily for trading;
• The liability is due to be settled within 12 months after the reporting period; or
• It does not have an unconditional right to defer settlement of the liability for at least 12 months after
the reporting period. Terms of a liability that could, at the option of the counterparty, result in its
settlement by the issue of equity instruments do not affect its classification.
Some current liabilities, such as trade payables and some accruals for employees and other operating
costs, are part of the working capital used in the entity's normal operating cycle. An entity classifies such
operating items as current liabilities even if they are due to be settled more than 12 months after the
reporting period. The same normal operating cycle applies to the classification of an entity's assets and
liabilities. When the entity's normal operating cycle is not clearly identifiable, it is assumed to be 12 months
(International Financial Reporting Standards, 2001).
Other current liabilities are not settled as part of the normal operating cycle but are due for settlement within
12 months after the reporting period or held primarily for trading. Examples of these liabilities are as follows
(International Financial Reporting Standards, 2001):
• Financial liabilities that meet the definition of held for trading;
• Bank overdrafts;
• Current portion of non-current financial liabilities;
• Dividends payable;
• Income taxes; and
• Other non-trade payables.
In examining liabilities, an auditor places primary emphasis on verifying what is recorded and what could
not be recorded. The auditor seldom finds amounts recorded as liabilities that are not liabilities, but
unrecorded liabilities are not unusual. They are inherent in an accounting process with periodic reporting.
Thus, the year-end procedure for payable is primarily a test for understatement, called a "search for
unrecorded liabilities." Also, the audit procedures should provide evidence about the reasonableness of
liabilities that are already recorded and presented in the financial statements.
A non-current liability, also known as a long-term liability, refers to a financial obligation in a company's
balance sheet that is expected to be paid after the period of one year. Non-current liabilities are due beyond
twelve months in the future, compared to short-term liabilities, which are due within one (1) year.
Long-term liabilities are usually substantial in amount and often extend beyond the current operating cycle
or one year, whichever is longer, or though payable within one year, will not be liquidated out of the existing
current assets. Long-term liabilities usually arise to finance long-term needs such as property, plant, and
equipment acquisition, in contrast to current liabilities, which are normally incurred to finance short-term
working capital requirements.
Debentures, long-term loans, bonds payable, and notes payable (sometimes secured by mortgages or trust
deeds) are the principal types of non-current liabilities. Debentures are backed only by the general credit
of the issuing corporation and not by liens on specific assets. Since, in most respects, debentures have the
characteristic of other corporate bonds, we shall use the term bonds to include both debentures and bonds
payable.
As discussed in Intermediate Accounting 2, shareholders' equity (SHE) is the residual interest of owners in
the net assets of a corporation measured by the excess of assets over liabilities. Generally, the elements
constituting SHE are:
a. Ordinary share capital
b. Preference share capital
c. Subscribed share capital
d. Share premium or additional paid-in capital
e. Retained earnings or accumulated profits
f. Revaluation surplus
g. Treasury shares
• Contributed capital – It is also termed as paid-in capital. This represents the amounts contributed by
the owners to the corporation. It includes the share capital and share premium of the corporation.
• Legal capital – It is the portion of paid-in capital that cannot be returned to shareholders in any form
during the lifetime of the corporation.
• The shareholders' equity section of the statement of financial position should be presented in
sufficient detail to provide a clear understanding of the corporation's capital structure and the
sources of capital currently in use.
• A corporation may issue different classes of share capital. Shares may be issued no-par or with
stated value; or with par value. Different classes include ordinary shares and preference shares.
When share capital is issued, its par value or stated value is credited to the share capital account.
The excess of the proceeds over the par or stated value is credited to share premium or additional
paid-in capital.
• Shares may be issued for cash or non-cash consideration. If the shares are issued for non-cash
consideration, the share capital is recorded at an amount equal to the following in order of priority:
1. Fair value of non-cash consideration received
2. Fair value of the share capital issued
3. Par value of the share capital issued.
• If there are share issue costs, they shall be debited to share premium arising from the share
issuance. If the share premium is insufficient to absorb such expenses, the excess shall be debited
to "share issuance costs" to be reported as a contra equity account as a deduction from the
following in the order of priority
1. Share premium from previous share issuance; and
2. Retained earnings.
• Treasury shares are shares originally issued by the corporation but reacquired for some purposes.
The cost method is used for accounting for the treasury shares in this example. Treasury shares
are recorded at cost regardless of whether it was acquired below or above par value. When
reissued, treasury shares are also credited at cost. Share premium account is adjusted for any
difference between the reissuance price and the cost of treasury shares. If the share premium is
insufficient to cover the difference, any remainder should be charged to retained earnings account.
• Retirement of share capital means redeeming the shares with a cancellation of the stock certificates
and reverting the shares to unissued basis.
• There are two (2) kinds of retained earnings: (1) Unappropriated retained earnings represent the
portion that is free and can be declared as dividends to shareholders. (2) Appropriated retained
earnings represent the portion that has been restricted and therefore not available for dividend
declaration.
• In any dividend distribution, only the outstanding shares are entitled to receive dividends.
• Share split does not affect the share capital of the company. It only increases or decreases the
number of outstanding shares outstanding and the par value, but the total share capital remains
the same.
• Detachable share warrants that are issued together with preference shares are recorded as equity
accounts for the amount of the proceeds allocated at the date of issuance. The allocation of the
issue price is based on the relative fair values of the detachable share warrants and preference
shares.
• Share warrants that are attached to bonds are assigned a portion of the proceeds using the residual
method. The market price of the bonds without the warrants is deducted from the total issue price,
and the remainder is assigned to the share warrants. When its holders exercise share warrants,
the amount of cash received plus the allocated value of the share warrants are credited to equity
accounts, share capital (at par value), and share premium for the excess over par.
• Share warrants outstanding is reported as part of the total share premium.
• Share options granted to key executives and officers of the company are recorded as compensation
expense over the period in which the services are received, measured at the fair value at the date
of grant. The amount of compensation expense recorded at each year of the vesting period is
credited to an equity account called "Share Options Outstanding." The amount of cash received at
the time of exercise of the options, together with the appropriate balance of the Share Options
Outstanding, is credited to equity accounts, Share Capital, and Share Premium.
Accounting Errors
Errors are unintentional misstatements in the financial statements, including the omission of an amount or
a disclosure (Salosagcol, Tiu, & Hermosilla, 2018)
In general, accounting errors include the following types (Kieso, Weygandt, & Warfield, 2019):
1. A change from an accounting principle that is not generally accepted to an acceptable accounting
principle. The rationale is that the company incorrectly presented prior periods because of an
improper accounting principle. For example, a company may change from the cash (income tax)
basis of accounting to the accrual basis.
2. Mathematical mistakes, such as incorrectly totaling the inventory count sheets when computing the
inventory value.
3. Changes in estimates that occur because a company did not prepare the estimates in good faith.
For example, a company may have adopted a clearly unrealistic depreciation rate.
4. An oversight, such as the failure to accrue or defer certain expenses and revenues at the end of
the period.
5. A misuse of facts, such as the failure to use salvage value in computing the depreciation base for
the straight-line approach.
6. The incorrect classification of a cost as an expense instead of an asset, and vice versa.
Error Correction
Companies treat errors as prior period adjustments and report them in the current year as adjustments to
the beginning balance of Retained Earnings. If a company presents comparative statements, it restates the
prior affected statements to correct for the error.
o Non-counterbalancing errors. Those that are not offset in the next accounting period. These
are also known as permanent errors. Included in this class are errors such as the recognition
of a capital expenditure as expenses and the omission of charges for depreciation and
amortization. Thus, if an entity fails to depreciate an item of property, plant, and equipment or
amortize intangible assets, the cumulative effect of the failure to detect a depreciation or
amortization error will not be corrected until the end of the asset life or until the asset is sold. A
correcting journal entry is necessary for a non-counterbalancing error.
The following are common counterbalancing errors and their effects on the profits for two (2) periods.
Type of adjustment error Effect on profit for the Effect on profit for
current year next year
Ending inventory overstated Overstated Understated
Ending inventory understated Understated Overstated
Failure to accrue expense at year-end Overstated Understated
Overstated accrued expense at year-end Understated Overstated
Failure to accrue revenue at year-end Understated Overstated
Overstated accrued revenue at year-end Overstated Understated
Overstated year-end prepaid expense Overstated Understated
Understated year-end prepaid expense Understated Overstated
Understatement of year-end liability for Overstated Understated
revenue received in advance
Overstatement of year-end liability for revenue Understated Overstated
received in advance
For a comprehensive audit case, refer to Pages 11-20 of 07 Handout 1 under 07 Evaluation of Audit
Evidence, Completion of Audit and Audit Reporting topic.